Index funds and ETFs are funds that simply buy every share in a stock market index, in the same proportions as the index, instead of having a fund manager pick shares. An index is a list of companies with a weight for each one. The Nifty 50, for example, lists fifty of India's largest companies. ETF stands for exchange-traded fund. Its units are bought and sold on the stock exchange during market hours, like shares, through a stock trading app. Units of an ordinary index fund are bought from the fund house itself, at a price worked out once a day, called the NAV, or net asset value.
This style is called passive investing. In an active fund, a fund manager and a research team choose which shares to buy, and the fund charges more for this work. A passive fund only copies the index, so it costs much less. A passive fund may charge 0.2% of the investment a year. Many active funds charge between 1% and 2%.
The fund does not choose the list itself. An index provider publishes the index: which companies are in it and what weight each has. The provider also changes the list from time to time, for example when one company grows larger than another. The fund's investment management system compares the fund's holdings with the index every day, and places the trades needed to match it.
Imagine an index fund that holds ₹1,000 crore. One company makes up 10% of the index, so the fund holds ₹100 crore of that company's shares. When investors add ₹10 crore of new money, the fund puts ₹1 crore of it into that company, and spreads the rest across the others in the same way. When the index provider replaces one company with another, the fund sells the old company's shares and buys the new one's on the same day. The small gap between the fund's return and the index's return is called the tracking difference. How much this gap varies over time is called the tracking error.
Many kinds of investor use these funds. Individuals invest a fixed amount every month. Managers of portfolio management services (PMS) use ETFs inside their clients' portfolios. Large pension funds also invest through ETFs.
An index fund is the opposite of a hedge fund. A hedge fund tries to beat the market, and charges a share of its profit for trying. An index fund only tries to match the market, at a low cost.